CHAPTER 17
Business Taxes and Tax Planning
Over and over again courts have said that there is nothing sinister in so arranging one’s affairs so as to keep taxes as low as possible. Everybody does it, rich or poor, and all do right, for nobody owes any public duty to pay more than the law demands; taxes are enforced exactions, not voluntary contributions. To demand more in the name of morals is mere cant.
Justice Learned Hand, US Supreme Court, 1947
This chapter presents the common taxes that businesses pay. It only discusses federal taxes. Many states and municipalities have similar, additional taxes if the practitioner is practicing in their authority. These taxes also follow the same principles outlined here, but the specific implementation of those principles and rules may differ. An accountant will help compute and report these taxes.
Tax laws and rates change frequently depending on governmental priorities and values. Taxes are not solely a revenue generator but also serve politicians to make a political statement. When politicians say “Big companies need to pay their fair share” or “We want to help small businesses,” they are making political, not governmental, financial statements. Tax laws, then, change for reasons other than purely revenue generation.
This chapter does not give specific tax advice or rates. Instead, it gives an overview of business taxes. Depending on the type of business entity, business owners will report these taxes to the government differently. The basic tax principles remain the same, though, regardless of the entity. Business owners report income and deductions, depreciate equipment, and pay employer‐related taxes. An accountant will complete forms and do other paperwork for the business owner. However, the business owner needs to understand the principles to communicate effectively with their accountant and other advisors.
THE BASIC BUSINESS INCOME TAX FORMULA
The general business formula for determining profit or loss is the basis for Schedule C, partnership, or corporate income tax returns (Box 17.1). The prototype, Schedule C, is the tax form that an individual proprietor uses to report profit or loss from operating a business, such as a dental practice. If someone practices as a partnership or a corporation, they report this information in a different form, but it contains similar information. Only income and expenses relating to this business should appear on this schedule. If someone has more than one business, they will file a different form for each of them. (Multiple dental office locations are generally considered to be one business.)
- Gross receipts
Gross receipts are the actual amount of money the practice collects, because most dentists use a cash basis for accounting. (If a practice owner uses an accrual basis, they must adjust this number.) This is not how much dentistry someone produced, but how much they collected in cash, patient checks, insurance checks, and capitation payments.
- Returns and allowances
If a dentist refunds money to an individual or third‐party payer (for an overpayment), they need to record it as a “return.” They have already received this money and accounted for it as a gross receipt. In this section of the form, they take it back off gross receipts if the situation warrants it.
- Cost of goods sold and/or operations
This metric is different for businesses that produce or sell a product (such as a dress shop) and businesses that provide a service (like dentistry). Product‐based businesses have a cost of goods sold (COGS), while service businesses use a cost of operations (COO). Generally, both show how much a company spends on producing or providing its primary product or service. This does not include general business costs such as rent, front‐office employees, or utilities. So, a product‐based company would include the cost of raw materials, inventory costs, and labor for production. A service company would include direct labor for providing a service (e.g. the assistant or hygienist), dental supplies and materials, lab costs, and operatory equipment costs.
- Gross income
Gross income is gross receipts reduced by any returns and the COO.
- Deductions
Deductions are the costs of doing business that are not a direct cost of goods or operations. They include office rent, advertising, accounting, legal fees, and management salaries. All non‐operating costs, such as interest and capital expenditures, are not costs of providing the services and so are included here. If an item is a capital expense (it lasts longer than a year), the business depreciates it, and that depreciation expense for the year is a deduction.
- Profitor loss
The profit or loss is how much money is left after a practice collects fees and pays the costs of running the business for the year. If collections are greater than expenses, the result is a profit. If expenses are greater than collections, then the result is a loss.
PRINCIPLES OF BUSINESS TAXATION
The principles of business tax planning remain the same from year to year. Specific rules, amounts, and thresholds change constantly, however. Congress ties some to the inflation rate. It changes others as it attempts to affect social policy and the economy. If someone understands the principles, specific changes will make more sense and be easier to implement.
INCOME
The Internal Revenue Service (IRS) has a simple rule concerning whether money made is “income” or not for tax purposes. It considers any money made to be taxable unless it has made a waiver for that specific type of income in the tax codes. By this definition, almost any income gained by the dental practice is taxable. This includes collections from patient payments, money paid by insurance companies, capitation payments, interest or dividends earned, the gain from the sale of assets owned by the practice, the value of trade or barter, and rebates. (This does not include money that the practice borrows.) Some business entities (C corporations) pay income tax on any profits in the business at the end of the tax year. Others (proprietorships, partnerships, S Corps, and limited liability companies [LLCs]) do not pay income tax, but let income and deductions flow through to the individual owners. The tax forms from these flow‐through entities tell the IRS who received money for the year. The IRS then checks to be sure that the individual has claimed the right amount of income on their individual tax return.
After the practice pays for the costs of doing business, the profit goes to the owner or employee of the business. The owner or employee then pays individual income tax on it. This includes profit from a proprietorship or partnership (self‐employment income), wages paid from an employer (proprietor or corporation), bonuses paid, profit‐sharing, and sometimes excessive employee benefits. The taxpayer must report the type of income because the IRS taxes it all differently. Ordinary income is the same as earned income. This money is from working. Individuals pay income taxes and Federal Insurance Contributions Act (FICA) or Self‐Employment Contributions Act (SECA) taxes on earned income. Investment income (e.g. capital gains, interest, or dividends) is unearned income. The IRS taxes it at a lower rate. Because it was not earned, individuals do not pay FICA or SECA taxes on this type of income. Tax laws and rates frequently change at the whim of Congress. So this text does not include specific rates or amounts. Practice owners should check with their accountants for the current tax rates.
Most dental practices fall under the cash basis accounting rules. This means that someone realizes income when they take constructive receipt of it. Therefore, they only pay taxes when they have control of the income and can use it for whatever purpose they desire. For example, assume a patient has a bill for $1200. They pay $800 on December 31 of year X1 and the remainder ($400) on January 2 of the year X2. The practice owner pays income tax on $800 of income in year X1 and pays tax on $400 in year X2, the year they constructively received it. By this definition, the practice owner pays no income taxes on accounts receivable because they are not income until patients pay them. (It is not income until the check crosses the receptionist’s desk.) Some large practices use accrual‐based accounting rules. These are accounting rules that most large corporations follow. Accrual‐based accounting causes income and expense recognition problems that do not favor the practice, so most use the cash basis rules.
If the practice owner sells a practice or a component of the practice (such as dental operatory equipment), they receive money for the asset(s). The IRS calls this money either a capital gain or ordinary income, depending on the circumstances. The difference is important, because a different tax rate applies to the two types of income. This leads to some obvious tax‐planning issues, which are discussed later in this chapter.
BUSINESS DEDUCTIONS
Definition
A deduction is an expense that is a cost of operating or maintaining the practice. The dentist may need to prove the amount and necessity of this business expense to the IRS, so they need to keep a receipt and canceled check for the item. They must be sure to keep excellent records. Canceled checks, by themselves, are not enough documentation.
The IRS considers no expense to be deductible unless it has specifically granted deductibility in the tax codes. Common dental office deductions are listed in Box 17.2. For a business expense to be deductible, it must meet all the following criteria:
- It must be “ordinary,” which means that it is common to other taxpayers in similar situations.
- It must be “necessary,” which means that it is helpful in the conduct of a trade or business.
- It must be “reasonable in amount,” which means that any other taxpayer would pay a similar amount for a similar good or service.
- It is not a personal expense (separate business from personal expenses).
- It is not a capital expenditure (accounted for as depreciation).
- It does not relate to tax‐exempt income.
The IRS expects everyone to follow these rules for deductions when they file their income tax for the year. However, the only way the IRS knows for sure that someone has followed the rules is if it audits that person and finds a problem. Therefore, many taxpayers take a risk, get away with breaking the tax rules, and do not get caught. This is a risky practice. If the IRS catches that person, there are substantial fines, penalties, and interest payments. They might even receive a prison sentence for gross or willful tax cheating. The IRS recently increased the audit rate on high‐income individuals (such as dentists), decreasing the chances of getting away with breaking the law. Accountants are very reluctant to advocate any tax reporting that does not strictly follow the tax laws. Their accounting licenses could easily be in jeopardy.
APPLICATION
There are several common issues to consider about deductions:
- Expenses in getting to be a practicing dentist (or any other new occupation) are not deductible. Therefore, expenses for dental education and the first state board exam are not deductible. The IRS considers a specialty to be a new occupation, so those expenses are not deductible. (Dentists frequently challenge this point in the tax courts.) The costs associated with setting up a practice are deductible.
- Expenses incurred for maintaining an occupation or profession are a required expense of doing business and are, therefore, deductible. Relicensure fees, continuing education expenses, dues, professional books, and publications are all deductible once someone is a practicing dentist. They may deduct the costs of taking another licensing exam after they earn an initial license.
- Business loan payments are not directly deductible. The interest paid on a business loan is a cost of business and is therefore deductible. The principal portion of the loan payment represents a long‐term asset. The value of the asset itself is deducted indirectly through depreciation.
- It never pays to incur an expense to “get a deduction.” If it is an expense someone would take anyway, then that expense ought to be structured so that it is deductible. The deductibility of an expense only lowers the cost to the taxpayer, it does not eliminate it.
- The first step in maximizing deductions is to learn which items are deductible, so as not to miss one or more authorized deductions. Examples of deductible and non‐deductible expenses for the dental office are in Box 17.2.
- The marginal tax rate influences the value of a deduction. (Chapter 10 describes the marginal tax rate.) A $1000 deduction in the 15% marginal tax bracket translates into a $150 tax saving. Conversely, the expense only “costs” someone $850 ($1000 − $150) instead of the full $1000. That same deduction in a 28% marginal tax bracket translates into a $280 saving.
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